Question

Suppose an investor observes a downward term structure of interest rate.

(1) According to the expectation hypothesis, what will be the investor's forecast about future change of interest rate (increase, decrease or unchanged)? Explain your argument. 

(2) What will the investor say about the future change of interest rate according to liquidity preference theory? Explain your argument. 

Answer 1

1. According to the Expectations hypothesis, the investors expectation about the future interest rate is that interest rates are going to be lower and long-term interest rates are going to be lower because there is an expectation of low growth into the economy and investor is expecting that there will be an impending recession or there would be e weak economic cycle so so they will be predicting a lower interest rate.

Investors are predicting a decrease in rate of interest in the longer period of time because they are expecting that economy will be facing an impending reception as yield curve inversion is a signal of of impending economic recession and it would mean that investor would be trying to estimate a lower growth for the economy in the longer period and he will be trying to discount that in the expectation about the long-term interest rate.

2. liquidity preference theory advocates that investors will always be wanting a higher liquidity and he will be preferring for short term bonds rather than long term bonds because short term securities are often with a higher rate of interest and hence, when there would be a downward yield curve, investor will be trying to not go for the long term bonds because he will be having double disadvantage as he would not be getting the adequate liquidity in the longer securities and he will also not get compensated for taking risk into the longer securities 4 lower liquidity.

Hence, at the time of downward term structure, investor will be avoiding the long term bonds because they will be offering with the lower rate of interest and which will be against the liquidity preference theory because investors will not be getting compensated for taking risk into investing into long-term assets as there highly illiquid.